What the stress tests reveal about Obama’s thinking on banks

Kyle, a long-time reader, recently asked why I think mark-to-market accounting actually matters. After alI, savvy investors know that accounting does not necessarily change cash flows. I think his question has a lot to do with not just accounting, but also with the stress tests.

Kyle writes:

My point is that it has really NOT changed, and people are trying to make it seem like it did. To be honest, I’m glad most people do feel that way, because it means those idiots in Congress will hopefully leave well alone. The capital raising that just occurred due to stress test mumbo jumbo has no connection to FSP 157-4. It is a requirement of GAAP to disclose when an accounting change has affected reporting, in order to explain the change. Out of the probably fifty different financial institution 10-Q’s that I’ve looked at, only one, Wells Fargo, indicated that 157-4 had a material impact on their reporting, which it did to the tune of 4B. The other 49 explicitly state, “157-4 had no material impact on our reporting, and we do not expect it to in the future.” It’s in the notes for anyone to read. I just do not understand how an accounting change which explicitly has had no impact on reporting (this is the ultimate point I am trying to make, the rule change was and has been almost completely meaningless), could lead to changes in whether or not a bank is undercapitalized.

Here is my thinking on that issue. I understand what Kyle is saying: FAS 157 guidelines will have no impact on reported earnings. I think it will and that this will alter behaviour. Wells and the Home Loan banks are just two early uses of the 157-4 alterations. Others may follow.

But more important is the affect on future writedowns. A bank only has to attribute its actions to 157-4 if it is amending prior accounting to reflect a change in asset designation to ‘holding to maturity.’ However, if it marks assets today as ‘holding to maturity’ and then is later forced to write down those assets, these writedowns will not be attributed to changes in the FAS 157 guidelines. So, anticipated future writedowns that would have gone through the income statement from marking to market will now be accounted for as held to maturity. This means the guidelines are affecting accounting and causing the company to report differently. In short: future writedowns for 2009 will be less because of FAS 157.

In my view, it is future credit card, jumbo loan and CRE exposure which will be most affected by this. These are areas where you should expect heavy pressure from securitized assets on bank balance sheets due to deterioration in income from credit card receivables,prime mortgage loans, and commercial real estate loans. What mark-to-market guidelines effectively mean is that banks will not have to reduce capital by nearly as much as had they not marked these assets as hold to maturity.

That is where the stress tests come into play. The stress tests are seen as the make or break for banks i.e. banks that don’t raise enough capital to meet the TCE requirements will be seized by the FDIC and treated to a BankUnited outcome. So the stress tests tell investors what the likely outcome is to beregarding nationalization. Translation: if you raise enough capital or are well-capitalized enough already to pass the stress test, we’ll leave you alone. You might even be able to pay back your TARP funds. But, if you can’t make the grade in a few months, you will be seized, cleansed, management thrown out, equity reduced to zero, and we will sell you on to private equity concerns or another bank or chop you up into little pieces. This is the IndyMac/BankUnited solution. Notice that bondholders did not lose any money here.

So, the stress tests and the capital raising exercise have revealed that no one is going to be nationalized unless they can’t come up with the capital. But since even Citi and Bank of America have been raising capital, few big banks are going to be seized. You probably saw Huntington (HBAN) and Fifth Third (FITB) coming to market and their shares coming under pressure as a result. But, HBAN said it was going to repurchase $470 million in preferreds immediately after it raised the common equity capital. Why? Tangible Common Equity. This is the measure by which the stress tests are being conducted. Preferred shares don’t count, so why not issue common and retire preferreds in order to boost your TCE? Remember, pass the stress test and you’re good to go. Fail and Sheila Bair plays the Grim Reaper on you, your management team, and your shareholders.

My conclusion from all of this building from March on was that bank shares would pop and I said so in April. Now, the rally has been way over the top and shares have come under pressure as these companies have gone to market for capital. However, if writedowns from CRE, Prime and Credit Card loans turn out to be less horrible in Q2 and Q3 as I anticipate, shares can rally again and again. Note, Meredith Whitney takes the opposite view i.e. that major losses are coming for banks – so I am aware of the other side of this argument.

I am left concluding that accounting alters behaviour and has an appreciable impact on share prices, especially when it dictates government intervention. This is why mark-to-market, tangible common equity, and the stress tests are all significant for the financial services industry.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.